Summary: The recession trade returned in a big way in the U.S. session, leading to lower bond yields and a wholesale capitulation in commodities. The biggest pain was seen in copper and crude oil, but gold was not spared either. Worries over Eurozone recession also took a leg up amid fresh gas supply concerns, sending EURUSD to 20-year lows. The rebound in interest rate-sensitive tech sector however helped equities to rebound and futures to charge higher in the overnight session, although China lockdowns and mass testing made a comeback. US data gets more attention with ISM services, JOLTs job opening and more importantly, FOMC minutes due today.
As we talked about yesterday the market was moving into a binary state of inflation vs recession and yesterday was most certainly about recession with commodity prices plunging 5% led by energy. The US 10-year yield also fell to around 2.8% driven by safe haven flows. The combined moves outside equities led to a perverse trading session in equities with our equity themes commodities and defence down 4.3% and 5.3% respectively while bubble stocks, NextGen medicine, and e-commerce baskets rallied more than 4% showing that retail investors are still very much active in these stocks. S&P 500 futures are trading lower at around the 3,813 level this morning with the 3,800 level being the natural gravitational point and yesterday’s low at 3,744 being the obvious support level to watch on the downside.
Mining and energy stocks led the charge lower, falling 4% to 8%. The locally transmitted cases in Shanghai surged to 24 for Tuesday and triggered two rounds mandatory mass PCR testing in three days in 12 out 16 districts of the municipality. The city of Xi’an ordered closure of restaurants, entertainment venues and schools after reporting 11 new cases. The resurgence of Covid-19 cases and the measures trying to stamp out transmission in major cities has raised much anxiety among investors about the risk of another wave of lockdown and sent equites lower.
The EUR has been weighed down because of the strength of the dollar amid the safe haven flows, but also the renewed fears of gas shortages in the Eurozone as Russia threatens to cut supplies further. EURUSD broke below the key 1.0350 support as we highlighted in our daily note yesterday, and that has brought back focus on parity with the USD. The ECB will continue to remain short of the Fed on tightening and recession worries are greater for the Eurozone economy than the U.S. Sterling bulls will also remain challenged amid the political jitters and a stagflation threat to the UK economy.
USDJPY remained capped below 136.40 despite a stronger dollar overnight with the yen once again acting as a safe haven. Still, lower yields had a role to play, and the Japanese yen may likely suffer again once inflation trade is back. US 10-year Treasury yields dropped below 2.80% overnight and USDJPY has traded below the 136-mark in the Asian session as the dollar eased. US ISM services data due later today, along with JOLTS job openings. Key focus will still be on FOMC minutes from the June meeting to watch for hints on potential rate hike path beyond the July meeting and the expected peak in interest rates.
The recent softening in refinery margins pointing to a moderation in the otherwise bullish outlook for energy, spread to crude oil on Tuesday with WTI and Brent both plunging by close to 10% on growing recession fears, and with low trading liquidity, and technicals exacerbating the sell-off. For now, worries about supply has been put on the back burner but may soon reemerge with Russia’s announcement on further cuts to its oil supplies and Saudi Arabia raising its August selling price to Asia to $9.3/bbl above its regional benchmark siting strong demand. With demand and supply both being a concern, volatility and price uncertainty remain high, as highlighted by diverging oil views for H2 from major investment banks. While Citigroup is calling for a collapse in oil prices to $65 by year-end, JP Morgan is warning for sky-high prices. Brent has returned to but has not yet broken the lower end of its established range of $100 per barrel.
Industrial metals remain the hardest hit sector with the combination of global recession angst and China’s zero-Covid tolerance hurting demand from the world’s top consumer. The Bloomberg Industrial metals index hit a 14-month low on Tuesday with copper suffering an extended sell-off, a move exacerbated by low liquidity, technical selling on the break below $3.50/lb, and not least macroeconomic focused funds selling as a hedge against recession. The sell-off has exceeded our expectations, but with China’s growth engine still sputtering and recession being the focus, further downside risks exist with the next level of interest being $3.14/lb, the 61.8% retracement of the 2020 to 2022 rally.
The US 10-year yield fell further yesterday to 2.81% as the US equity market rallied on lower commodity prices and the US 5Y inflation swap fell to 2.81%, the lowest level since early February. The recent moves in inflation expectations and bond yields have almost erased the positive real yield again, explaining the excessive behaviour we are observing in low quality equities. The lower real yield is also reflecting that the market believes that the tighter financial conditions have already done most of the job of curtailing inflation and thus the thinking is that pressure is coming off for the Fed.
What is going on?
While recession fears were the overall theme, the stronger dollar ended up being the trigger that yesterday sent most raw materials, except European gas, sharply lower. The weakness is undoubtedly being exacerbated by the low liquidity season where holiday-focused traders and investors are most concerned about reducing exposure. Since hitting a record peak a month ago, the Bloomberg Commodity Spot Index has fallen 20% in response to the FOMC aggressive rate hike stance and increased the risk of recession. With recession now the dominant focus, the focus on long-term structural supportive supply issues has faded but not gone away. The weakness has also extended to key food commodities with cooking oils and grains plummeting, thereby lowering, but not yet removing worries about a global food crisis.
With increasing anticipation of an incoming recession in the U.S., the front end of the U.S. yield curve is now pricing in a 3.33% terminal rate in the Fed Fund in this rate hike cycle, nearly half-a-percentage-point below the median projection of 3.8% by the Fed in its June FOMC dot-plots. The 2-year vs 10-year U.S. treasury yield curve has turned inverted once again, with 10-year T-note yield at 2.82%, sitting one basis point below the 2-year at 2.83%.
Given recessionary risk decreased after the oil price fell back to $100, Aussie bond yields fell to 3.46% - this fuelled tech stocks today. But we argue this is a disillusionary and probably short-lived rally, as bond yields are likely to rise again. That said, Tech stocks were up the most today on the ASX, with many names up 7-13%. Tech businesses are facing headwinds and typically don’t do well when economic growth slows. Also consider, investment managers are being stopped out of their shorts. As for the worst performers today, huge profits/selling is taking place in oil stocks which we might continue to see for some time while oil is pressured. While Copper and iron ore stocks are also being sliced after both commodity prices fell.
According to Spiegel information, the federal government is now creating the legal basis for taking over energy companies. The draf is said to have already been agreed with the factions of the traffic light coalition. This officially aims to regulate financial aid up to and including a state entry in order to be able to avert the bankruptcy of a gas supplier. Germany is facing a tough time. The country’s natural gas storage occupancy is rather low compared to other European countries, at 62 % against 97 % for Portugal, for instance. If the next winter is very cold, expect supply issues in Germany and certainly in many other European countries.
What are we watching next?
The US services sector PMI figure has declined from 62.3 in December to 55.9 in May suggesting the US economy is cooling but still running strong. Economists are looking for a further slowdown to 54 and a downside surprise would bolster the current safe haven flows and recession fears. The JOLTS Job Openings report for May is released simultaneously with the ISM Services figures and is also a watched report to gauge the dynamics in the US labour market. A lower JOLTS figure will immediately be viewed as a little less pressure on wage inflation.
Earnings Watch
It happens rarely but this week has no important earnings but the Q2 earnings season start next week with companies such as PepsiCo, Fastenal, Delta Air Lines, JPMorgan Chase, Morgan Stanley, Conagra Brands, PNC Financial Services, UnitedHealth, Well Fargo, Charles Schwab, US Bancorp, BlackRock, State Street, and Citigroup.
Economic calendar highlights for today (times GMT)
Titled "The Runaway Train” and can be accessed here.
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